Adam Smith, David Ricardo, And You

Today, let’s learn a bit about economics. As I mentioned a few days ago, recently I’ve been reading a great deal about economics in an effort to get a better grasp on how money works on a larger scale than in my own wallet. In this effort, I started at the beginning, reading a pile of classic books on economics and working forward, and recently I reached David Ricardo’s 1817 classic The Principles of Political Economy and Taxation. It made me consider some of the implications of frugality – and whether it’s cheaper to hire someone to clean your house.

But let’s back up a bit. Before I read Ricardo’s book, I read Adam Smith’s slightly older book, The Wealth of Nations (at the same time as P.J. O’Rourke’s hilarious reader’s guide to it, On the Wealth of Nations). In that book, Adam Smith talks about absolute advantage, a concept that’s easy to understand. Absolute advantage merely refers to the advantage that someone has when they can produce more output per unit of effort than someone else. For example, if your next door neighbor Jim makes $25 per hour of work and you only make $18, Jim has an absolute advantage over you – he invests less time for every dollar earned than you do.

Understanding Comparative Advantage

This is the idea that Ricardo talks about, and it’s best explained in an example.
Let’s say that Annie and Bonnie both have small gift shops in a small town where they both sell their homemade soaps and their homemade candles. Annie can make a homemade candle for fifty cents, but making a bar of soap costs her a dollar. Meanwhile, Bonnie can make homemade soap for a quarter, but a candle costs her a dollar to make. In other words, Annie is much more efficient at making candles and Bonnie is much more efficient at making soap. If they’re willing to trade – Annie gives candles to Bonnie in exchange for soap – they’ll both make substantially more profit that way. That’s comparative advantage in a nutshell.

Comparative advantage works in everyone’s life

Let’s say, for example, that I can make $20 an hour working at my own business – each hour of time I invest in it earns me $20. It takes me an hour to mow my lawn, but it’s a chore I know I have to do. Now, a teenage neighbor kid has a killer mower and is in excellent shape – he can bust through my lawn in a half an hour. He comes up to me and says “I’ll mow your yard for you for $10.”

The cheapskate choice may not be the most financially stable

The cheapskate choice to say no and just do it myself does not always work. If I tell the kid no, I spend an hour mowing my own lawn to save myself the $10 I would have to pay him – but I lose the $20 I would make if I spent that hour working on my business. Instead, what I should do is pay the kid $10, then spend the next hour (that I would have been mowing) working on my business, earning $20. Net profit – $10.

You can carry this forward to all sorts of cases. There’s a woman on our block who does housecleaning at a rate of $54 for four hours of cleaning (remember, folks, this is Iowa). If I’m working on my businesses while she’s doing that, does it make sense to hire her to clean the house one afternoon a week? I’d earn $80 and spend $54 – that still leaves $26 for me for four hours’ work, a net profit.

There are just a couple important caveats. First, do you know exactly what you earn for each hour of your work? I find that long term calculations work best here – let’s say, over three months, I spend 200 hours on a side business and I bring in $4,300 after taxes and expenses. It’s probably fair to believe that I earn $21.50 an hour for the time invested.

Second, would contributing more hours directly lead to more income? If I added an extra twenty hours to that business time, would I bring in another $430? Probably not directly – but I could spend that extra time building up more business for later or improving the infrastructure to increase my efficiency.

Use comparative advantage where it’s obvious

If I can get the neighbor kid to mow the grass for $10 while I can directly earn $20 working at my side business in that same timeframe, I should hop on board. This is the same logic that convinces people to use daycare, for example.

Of course, one should be careful if the value isn’t as obvious. If I were to hire that housecleaner, would I really be able to utilize those extra four hours enough to earn more than $54? It’s possible that over the long term I will, but it’s not a guarantee. These situations are judgment calls based on what’s going on with your life and activities, but it’s worth considering. For me, I may just hire that housecleaner.

Who says that economics texts from the early 1800s aren’t valuable and relevant to our lives today?

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